The Mysterious Case Of Recession Risk: December 2011 Edition

by: James Picerno

Will the threat come from within or without? Or are we set to be a two-time loser? Perhaps the more pressing question is whether it’ll come at all?

The odds of a new recession appear low to many analysts, but the Economic Cycle Research Institute's weekly leading index (WLI) is still anticipating a fresh period of contraction. The latest reading of the rolling growth rate for ECRI's WLI is -7.5, the group reported on Friday. That’s up slightly from the previous week, but it's not enough of a change to spur a revision in ECRI's recession call that still stands since it first issued the warning in late-September.

The appearance of a stronger U.S. economy over the past month or so vs. the ongoing recession forecast by ECRI is gaining attention as analysts consider if the improving trends in some of the economic news are misleading us. The latest addition for thinking that there's no recession coming these days is the weekly initial jobless claims report. Last week's update suggests that the labor market is strengthening. It's always dangerous to rely on one number for predicting the economic cycle, of course, but the sharp decline in this leading indicator looks compelling for expecting the labor market to maintain a moderate growth rate if not accelerate.

A new research note from the St. Louis Fed muses: Initial Claims and Employment Growth: Are We at the Threshold? It's not yet clear, the author concludes, but the possibility of stronger employment growth isn’t beyond the pale. If so, the odds of a new recession appear low.

But ECRI doesn’t agree. The consultancy has a strong record of making cyclical calls, but no one should assume its crystal ball is flawless. A complicating factor is ECRI's black box methodology. One blogger has tried to deconstruct ECRI's process, but it's difficult to make any hard and fast conclusions when you're an outsider looking in. You can find deeper context for ECRI’s process in a book co-authored by two of the firm’s principals: Beating the Business Cycle: How to Predict and Profit From Turning Points in the Economy. But as The Wall Street Journal recently noted, the index that ECRI publishes weekly for all the world to see "is not the one... used when it made its famous recession call a couple of months ago — they relied on a longer-term leading indicator, which they only show to paying clients."

If there's a risk of a new U.S. recession, perhaps the biggest threat comes from beyond its borders. France seems to be in a recession, implying that the eurozone overall will follow, as the latest update of the Markit Eurozone PMI Composite Output Index implies. Britain’s economy looks wobbly too.

If Europe rolls over, China may succumb too, thanks to the Middle Kingdom’s heavy reliance on exports to Europe. It all adds up to new headwinds for the U.S. “Alone, conditions in Europe might not cause another U.S. recession,” writes economist Peter Morici, “but in concert with China's renewed mercantilism, banking problems and higher gasoline prices, those could sink America quite nicely.”

Christine Lagarde, managing director at the International Monetary Fund, is quite pessimistic as well, warning that the global economy is at risk of a severe downturn.

We may be doomed, but the threat isn’t obvious in the last full month—October—of economic reports for the U.S., as I noted here. The numbers so far via the November updates don't reveal any smoking guns either. The year-over-year trend in several key indicators remain positive. Retail sales, for instance, are firmly in the black through last month. Industrial production slipped modestly on a monthly basis for the first time since April we learned last week, but the annual change is 3.7% vs. November 2011--an historically strong rate of growth for industrial production.

The stock market, meanwhile, seems to be on the fence. Every recession in the past half century has been accompanied by a 12-month decline in the S&P 500. At the moment, the market’s marginally higher vs. the year-earlier level.

On balance, looking at industrial production, retail sales, nonfarm payrolls and other indicators suggests that another recession isn’t near. But if there is a downturn just around the corner, macroeconomic forecasters may have to rethink their assumptions. The notion that a recession can arrive with minimal warning is disturbing, but not necessarily surprising. Maybe we're looking at the wrong signs. Forecasters generally failed to anticipate the Great Recession, notes Simon Potter, the New York Fed’s director of economic research. There’s hardly compelling evidence for thinking that it'll be different this time.

There are always exceptions among the seers, of course. ECRI has a history of seeing trouble when others don’t. John Hussman of Hussman Funds also made a timely recession call ahead of the last downturn. What does Hussman expect these days? “Recent U.S. economic reports have improved modestly from the clearly negative momentum that we saw in late-summer,” he wrote earlier this month. But he’s not convinced that the good news delivers the all-clear signal. A deeper review of the data, Hussman explained, seems to fall in line with ECRI’s recession prediction:

Unfortunately, the underlying recessionary pressures we observe are largely unchanged. When we take the present set of economic evidence in its entirety, we see very little evidence of a meaningful reduction in recession risks. Indeed, the evidence from the rest of the world, both developed and developing, reinforces the expectation that the global economy is approaching a fresh contraction.

If so, we should see confirming numbers in the U.S. data soon. And if we don't? Well, cyclical analysis may be set to get a lot more complicated. Stay tuned.